Is Japan thinking about tearing up LNG purchase agreements? What will be the impact on the Australian and global gas markets?
Global LNG trade is based on the trinity of long duration contracts, oil indexed pricing and destination restrictions. The long contracts align banks, gas sellers and gas buyers and bind them to remove risk, from the endeavour. Oil indexed pricing gives gas buyers and sellers upside and downside price exposure, access to financial markets for hedging and risk management, and lots of commodity analysis expertise. Destination clauses, a standard shipping term dating back to the very earliest days of international trading, prevent gas buyers from turning into gas sellers and competing with their source of supply for markets. The vast majority of Australia’s LNG shipping is contracted in this way.
Much of the new LNG from the US is sold Free on Board (FOB), meaning the buyer takes title as the gas is loaded onto the ship that has been chartered by the buyer. FOB gives the buyer lots more flexibility to either bring the cargo to their home market or to find an alternative market. If buyers are able to on-sell unwanted cargos to others, it has the effect of creating price competition between LNG cargos as they seek buyers. It has the potential to delink LNG pricing, somewhat, from oil indexed pricing.
Why the Japanese challenge?
In the face of a shrinking population (and hence demand for energy), deregulating gas and power markets, a government keen to meet climate commitments and restart the nuclear fleet, Japan’s gas buyers find themselves long on LNG – they have over purchased.
They could build regasification facilities at all of their gas import terminals. But there are dozens of such plants, not enough time to carry out the refurb, and who would pay for the retrofits, particularly at a time of market deregulation?
The easier path is to challenge the contracts and have them overturned. There is precedent – the EU carried out a similar exercise against Russian pipeline gas that was also contracted in the trinity model. They simply declared parts of the Russian contracts anti-competitive and that was that.
The consequences of this action, if successful, are truly seismic:
- Spot markets grow – freeing up LNG to supply any available market gives a big boost to the emergence of spot
- Demand boosted – a bigger, deeper and more liquid spot market takes supply risk away and can help smaller markets enter without having to meet the upfront commitment demanded by the trinity
- Hubs in demand – lively spot markets working in tandem with sophisticated financial markets can help take risk out of the dependency on a steady supply of a commodity without the backstop of a long contract. Singapore, Tokyo and Shanghai are all vying to set up this infrastructure
- FERC defanged –the Federal Energy Regulatory Commission recently blocked a US LNG project from proceeding because the project developer could not demonstrate there was a market for the LNG. If there’s a big, deep and liquid LNG spot market, the FERC argument no longer holds and should unlock fresh supply in the US
- Pricing basis – we might see a progressive adoption of more flexible contractual mechanisms that can benefit both parties, eg. profit sharing provisions between buyers and sellers that mitigate the impact of cargo diversions
- Pricing falls –the gap between spot LNG price and contract price should close, and at the spot level.
- More court challenges –Korea, China, Taiwan and others could all follow suit and launch their own court challenges
- Greenfield projects slowed – area prioritisation of the attractiveness of proposed projects will occur, giving the edge to economically viable FOB projects
- Trading skills in demand – navigating a much bigger and more liquid LNG market will require a step up in trading capabilities
- Cash flow pressures – Australia’s LNG projects will come under more margin pressure if the bulk of their trade is declared anti-competitive. It’s not inconceivable the pressure will prove too great on the industry’s weaker players, and those more leveraged will need to raise fresh capital or consider more strategic alternatives such as asset sales or merger with others
- Royalty pressures –the royalty bounty will simply vanish as the market competes away the profits this industry generated in its golden age from 2010 to 2014.
It would be logical competition law would need to be consulted in this instance. It cannot be the first time a willing contracting party has remorse over the terms of their contracts. METI may not be successful.
That said, players in the market should not fear this development. In the short-term it seems a threat, but it’s actually a healthy step towards a more liquid and transparent market, and one taken by the oil industry in the 1980s and more recently by the coal industry. Gas is different, but that should not block progress.